The Nexus between Institutional Quality and Global Market Structure: Export versus FDI

Abstract

Though many important links between the productivity/resource differences of countries and their trade patterns have been highlighted by traditional trade theories, much less attention has been devoted to studying the role of institutional quality in global trade/investment patterns. To study this role, the present paper develops a two-country general equilibrium trade/FDI model that solves a complementarity problem with different firm types. Four different firm types—two types of national exporting firms and two types of multinational firms based in each country—compete in the global market and emerge endogenously. By incorporating multinational firms and country-specific institutional quality into the traditional factor endowment trade theory, this study investigates the impacts of institutional quality on the equilibrium global market structure (regime changes) in detail. The study shows that even a small variation in institutional quality can greatly affect the equilibrium of the global market structure in both magnitude and direction. In particular, multinational firms that have to incur higher fixed setup costs than national competitors are more influenced by country-specific institutional quality, and base their headquarter in countries with better institutional quality, which is not captured by traditional trade theories in which institutional quality factors are not considered.